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Fed Discusses ways to avert deflation

Bloomberg
By Craig Torres and Steve Matthews
January 7, 2009

Jan. 7 (Bloomberg) -- Federal Reserve officials revived the prospect of setting an explicit
target for inflation to counter the risk that the worst economic slump in the postwar era will
trigger a broad decline in prices.

The Federal Open Market Committee at its Dec. 15-16 meeting discussed ways to avert deflation
while approving a reduction in the benchmark interest rate to as low as zero, according to minutes
of the gathering released yesterday. The FOMC also considered increasing emergency loans that have
doubled the Fed's balance sheet to $2.3 trillion in the past year.

Policy makers "face considerable uncertainty about how inflation expectations could evolve,"
said Brian Sack, deputy director at Macroeconomic Advisers LLC in Washington and a former Fed
economist. "That enhances the argument for taking the further step and adopting an explicit
inflation objective."

By setting a goal for price increases, the central bank would adopt a measure that the U.K.,
Sweden and other countries have used to anchor policy and build credibility with the public.
Chairman Ben S. Bernanke made a target one of his priorities when he took the helm three years
ago, though a 2007 review of Fed communications stopped short of that objective. Now, with
inflation retreating and the economy contracting, a target could be used to justify a more
expansive policy.

Inflation Forecast

One measure of inflation, the personal consumption expenditures price index, minus food and
energy, could rise at less than 1 percent this year, and only 0.5 percent in 2010, according to
forecasts by Sack's firm.

Central bank officials discussed providing "a more explicit indication of their views on what
longer-run rate of inflation would best promote their goals of maximum employment and price
stability," the minutes said. Such a target may "help forestall the development of expectations
that inflation would decline below desired levels, and hence keep real interest rates low."

In the economic forecasts presented to policy makers by Fed staff at last month's meeting, the
projections for gross domestic product and the job market were cut, the minutes showed.

"GDP was expected to fall much more sharply in the first half of 2009 than previously
anticipated," and the "unemployment rate was likely to rise significantly into 2010," according to
Fed staff. The central bank's economists still anticipated a recovery in growth to a pace faster
than the U.S. trend rate in 2010.

Job Losses

Two reports today indicated that payroll losses deepened in December. ADP Employer Services
said companies eliminated 693,000 jobs in December, the most since the group began keeping records
in 2001. Chicago-based Challenger, Gray & Christmas Inc. said firings announced by U.S.
employers rose 275 percent last month from December 2007, to 166,348.

The Labor Department may say in two days that payrolls fell by 500,000 in December, bringing
last year's decline to 2.4 million, the most since 1945, according to the median estimate of
economists surveyed by Bloomberg News.

Setting an explicit inflation goal would reinforce expectations that the central bank will make
a commitment to withdraw cash when the economy shows signs of a recovery.

Some policy makers last month saw "significant risks that inflation could decline and persist
for a time at uncomfortably low levels," the minutes said. Price increases will probably "continue
to abate because of the emergence of substantial slack in resource utilization and diminishing
pricing power."

'Substantial' Danger

Fed officials saw "substantial" risks to the slumping economy last month and indicated "the
economic outlook would remain weak for a time and the downside risks to economic activity would be
substantial," according to the minutes.

"Rates are going to be low for a long time," said Vincent Reinhart, former director of the
Fed's Division of Monetary Affairs, who is now a visiting scholar at the American Enterprise
Institute in Washington. "They see the economy as extremely weak. It is a dark document."

Economic growth declined in the third quarter at the fastest rate since 2001 as unemployment
rose and home values, housing starts, auto production and consumer spending fell. Analysts
downgraded forecasts last month, with economists at Morgan Stanley and JPMorgan Chase & Co.
predicting a contraction in gross domestic product of about 6 percent for the fourth quarter, the
biggest decline in 26 years.

Policy Options

Policy makers discussed an array of alternative policy tools at the meeting last month,
including communicating their expectations for interest-rate changes and expanding the balance
sheet by taking on more loans and bonds that private creditors refuse to hold.

The FOMC also discussed setting a target for growth in measures of money, such as the monetary
base. While a "few" policy makers favored a numerical goal for money growth, most preferred a more
open-ended "close cooperation and consultation" with the Fed board on how to expand assets and
liabilities.

"Going forward, consideration will be given to whether various quantitative measures would be
useful in calibrating and communicating the stance of monetary policy," the minutes said.

The central bank will have difficulty scaling back its auction of loans and other emergency
programs without upsetting the bond market, former St. Louis Fed President William Poole said in a
Bloomberg Television interview.

Signal for Policy

"The market will take that as being a signal that monetary policy is tightening and that is
going to set off substantial reaction in the bond market, maybe the equity markets too," Poole
said.

President-elect Barack Obama yesterday called for a record stimulus to prevent the recession
from deepening. His plan aims to create or save 3 million jobs and may cost about $775
billion.

Policy makers discussed "possible refinements to the committee's approach to projections,"
including providing more information about individual views on "longer-run sustainable rates" of
unemployment, inflation and economic growth.

The committee, after Bernanke's urging, started publishing three-year forecasts for growth,
inflation and unemployment in the minutes of the October 2007 FOMC meeting.

The third year of those projections is viewed by analysts as a signal of policy makers'
preferences for prices, unemployment and growth. The third-year projection may be less valuable in
communicating goals because slack in the economy may continue to depress inflation through 2011,
Sack said.

To contact the reporters on this story: Steve Matthews in Atlanta at
smatthews@bloomberg.net
Last Updated: January 7, 2009 08:45 EST